Having some idea of the history of ­do-it-yourself super can be very handy for those wishing to understand the rationale behind some of the often complicated rules.

Why, for instance, are DIY funds restricted to investing no more than 5 per cent of their total assets in an investment regarded as an in-house asset? A reader asks this, adding it seems strange that if an investment is successful and grows to represent more than this proportion, it will penalise the fund.

His question relates to a strategy outlined in this column last weekend where a super trustee asked about his fund making a joint investment in a printing business, with the other investor being a DIY super fund in which his sister and her husband are the member trustees.

They each propose to own 50 per cent of the business through a unit trust arrangement.

The fact that there is a family relationship, which creates an association between the two funds, makes the investment an in-house asset which, in turn, restricts the amount each can invest to no more than 5 per cent of each fund’s total assets on an ongoing basis. This rule requires the investment and the total fund assets to be constantly monitored to ensure the limit is not exceeded as this has the scope to create a problem for the fund.

Business can create in-house links

If it is exceeded, says DIY super auditor
Martin Murden
of the Partners Wealth Group, and the investment value becomes more than 5 per cent of one or both of the funds, then the fund or funds must dispose of the investment because the in-house asset rule has been breached.

What is interesting about the strategy, says Murden, is that if the investments were made by two funds where there was no association, it would not be classified as an in-house asset. But just because two funds don’t have members who are related (as outlined in the strategy), it doesn’t mean there can’t be an in-house link.

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Arrangements that can also create in-house assets include joint investments by members of funds where there is a business connection through a company or trust.

That said, it’s true that if the DIY fund trustees have made a wise investment they could expect to receive both income distributions from the trust and also see the value of the units increase.

It’s also true that a problem could occur if the value of the investment increased at a greater rate than the balance of the fund.

Once the investment value represents more than 5 per cent of the fund’s assets, the fund would be in breach of the in-house asset rules.

Fund auditor judges breaches

The initial judge of whether the fund is in breach is the fund auditor, says Murden. Influencing this decision is the dollar amount of the investment value above 5 per cent.

If it was $30,000 or more, the auditor would have to issue an Audit Contravention Report, notify the Australian Taxation Office and request the trustees to advise how they planned to rectify the breach.

For a smaller breach, say $10,000, the auditor would have the option of notifying the ATO or asking the trustees to resolve the matter another way.

Assuming they did not expect the situation to rectify itself, perhaps as a result of a revaluation of fund investment, an option for the trustees would be to sell units equal in value to the dollar value of the breach.

These can be sold, says Murden, to the members of the fund. The sale would have to take place at market value. Where a fund is not paying pensions, any profit on the sale would be subject to tax at the rate of 15 per cent on the realised gain. This would be reduced by a third where the investment has been owned for more than 12 months. A fund where all members are in pension mode would have a nil tax rate on its income including capital gains.

If the members have met a condition of release, and reaching age 65 is one such condition, the excess units could be transferred to them as an in specie benefit. This means they would own the units at no cost.

Of course these scenarios assume it will be a successful investment.

The other side of the coin is investments that don’t succeed that end up being worth less than 5 per cent. Limiting the investment value reduces any temptation to invest more money which many funds certainly did in bygone days.

Why the 5 per cent restriction?

Why DIY super funds are restricted to owning 5 per cent of an investment classified as an in-house asset is an interesting question that goes back two decades to 1993 when the Superannuation Industry (Supervision) Act first became law.

The law, says
Graeme Colley
of the SMSF Professionals Association of Australia, ended certain activities by DIY funds that went back to the 1980s when most DIY funds were established by people in small business who utilised the super they contributed as working capital for their businesses.

Some of this capital was invested in more curious assets such as luxury cars were leased to fund members.

This is interesting, given that every so often there are groups that lobby to allow DIY funds to be used to finance investments without being aware this right was once available, albeit at extreme levels.

Under arrangements described as “loan backs", any contributions that went into what were then called excluded super funds (usually on June 30 every year) could be lent back to the business on July 1.

Rather than developing a pool of savings to finance future retirement, many of the funds that preceded DIY funds were more like working capital arrangements, says Colley, who in 1993 worked for the Commonwealth government’s Insurance and Superannuation Commission, which preceded the Australian Prudential Regulation Authority.

This body regulated all super until 1999, when the Australian Taxation Office took over the supervision of the newly created DIY, or self-managed, super funds.

Before the law changed in 1993, in-house assets were actually defined as loans or an investment in an employer sponsor or someone associated with an employer sponsor of an excluded fund, so named because different rules applied to them.

In 1997, a survey of excluded funds found that 20 per cent were investing in unit trusts controlled by the members or an employer.

Half of the funds then borrowed money to invest, with slightly more than this then renting or leasing fund-owned assets to members or employers. Because they could be geared, the value could be more than the value of the super which highlighted risks that were ultimately regarded as unacceptable for a retirement savings arrangement.